On China's monetary policy and asset prices

This article investigates the dynamic and long-run relationships between the monetary policy and asset prices in China using monthly data from June 2005 to February 2012. Johansen's cointegration approach based on the Vector Autoregression (VAR) and the Granger causality test are used to identify the long-run relationships and directions of causality between asset prices and monetary variables. Empirical results show that monetary policies have little immediate effect on asset prices, suggesting that Chinese investors may be ‘irrational’ and ‘speculative’. Instead of running away from the market, investors rush to buy houses or shares whenever tightening monetary actions are taken. Such seemingly irrational and speculative behaviour can be explained by various social and economic factors, including the lack of investment channels, market imperfections, cultural traditions, urbanization and demographic changes. The results have two important policy implications. First, China's central bank has not used and should not use interest rate alone to maintain macro-economic stability. Second, both monetary and nonmonetary policies should be deployed when asset bubbles loom large to avoid devastating consequences when they burst.